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Not Exactly True

Jonathan Clements

THERE ARE FINANCIAL issues on which reasonable people can disagree. This article is not about those issues. Instead, it’s about issues where people disagree—because one side has a fundamental misunderstanding.

These misunderstandings, I fear, are leading folks to shortchange themselves financially—and we’re talking here about some of the most important money decisions we make. Examples? Based on the comments I’ve received, here are three widespread misconceptions:

1. Commissions equal trading costs. If you think it’s free to trade stocks because you aren’t paying a brokerage commission, think again. Every time you buy or sell, you lose at least a little to the bid-ask spread, the difference between the higher price at which you can currently buy a stock (the ask) and the lower price at which you can sell (the bid). The difference is pocketed by Wall Street’s market makers.

The bid-ask spread means that if you bought a stock and sold it seconds later, you might lose a few cents per $100 on the very biggest publicly traded companies—and perhaps $3 or more on a micro-cap stock.

That brings me to a key decision that many indexers make: Should you buy index mutual funds or exchange-traded index funds (ETFs)? When you purchase an index mutual fund, you buy directly from the mutual fund company involved and get the price as of the 4 p.m. ET market close. When you buy an ETF, you put in an order through your brokerage firm and you can invest at any time during the trading day.

Consider Vanguard Group, which offers its index funds as both mutual funds and ETFs. The ETFs often have slightly lower annual expenses. But those lower ongoing costs come at a price: You get nicked for the bid-ask spread on your trades.

How much might you lose? During the trading day, check out the spread on funds like Vanguard’s S&P 500 ETF, Small-Cap ETF, FTSE Developed Markets ETF and FTSE Emerging Markets ETF. (Don’t look when the market is closed, because the spread often appears far larger than it is during market hours.) The Small-Cap ETF is no cheaper than Vanguard’s mutual fund version, while the other three funds are between 0.01 to 0.04 percentage point per year less expensive. Those annual savings would offset the spread—but, based on eyeballing the bid-ask spread over the course of a few weeks, you might need to hold the ETF for at least two or three years to come out ahead. The upshot: ETFs are typically a better bet for those with longer time horizons, but not for those inclined to trade.

A digression: Some readers have written to me, arguing that because you can put in a limit order for an ETF and thus you know what price you’re getting—assuming the order is executed—ETFs are superior to mutual funds, where you might put in an order at 3 p.m. ET and get a wildly different price when your buy or sell order is filled at the 4 p.m. market close.

I find this argument unconvincing. To be sure, with mutual funds, you don’t know precisely what price you’ll get. Sometimes, that price will be higher than when you put in the trade. Sometimes, it’ll be lower. Given that nobody can forecast what will happen to stock prices during the course of the trading day, I don’t feel this uncertainty is so terrible and, overall, the brief time lag probably helps as often as it hurts.

2. All annuities are terrible investments. Many folks hear the word “annuity” and immediately stop listening, which is perhaps what insurance companies deserve after decades of sales abuses involving variable and equity-indexed annuities.

Still, with their point-blank refusal to consider any annuity product, many retirees are missing out on one of the few remaining ways to generate a healthy amount of income in today’s low-yield environment. I am, of course, referring to my old favorite, immediate fixed annuities.

With an immediate fixed annuity, you and a bunch of other retirees contribute to a pool of money overseen by an insurance company. The insurer promises to pay you income every month for life. The income stream can be impressively large, in part because those who die early in retirement effectively subsidize those who live longer.

But what about the cost? Annuities are famous for paying fat commissions to the financial salespeople involved. But that isn’t true of immediate fixed annuities, where a salesperson might receive a commission equal to just 1% to 3% of your total investment—far less than the 5% to 8% that he or she might receive for selling a variable or equity-indexed annuity. Think of it this way: If you buy an immediate fixed annuity that ends up paying you income for the next 25 years and the salesperson gets a onetime 1% commission, that’s the same sum that many folks pay to a fee-only financial planner every year.

If immediate fixed annuities aren’t all that expensive and they remain one of the few ways for retirees to generate a healthy amount of income, why are they so unpopular? Even if folks better understood them, there will—I suspect—be one stumbling block that never goes away: People just hate the idea of an investment whose value hinges on them living a long life. That brings us to our third topic.

3. You should claim Social Security early and invest the money in stocks. Receiving Social Security is rightly compared to collecting interest from government bonds. Both involve a similar level of risk.

Suppose you claimed benefits at age 62, the earliest possible age, and invested those benefits in government bonds that had a zero inflation-adjusted return, which is a generous assumption these days. For that to be the right move financially, you need to be dead by your late 70s. If you live any longer—which the life expectancy tables say you should—you would have been better off delaying Social Security until age 66 and perhaps age 70, so you got the larger monthly benefit.

For those who think claiming Social Security early is a smart strategy, the notion of committing to an early death is no doubt a tad unpalatable. What to do? How about if they took benefits early and then put the money in stocks? Given the higher expected return from stocks, claiming benefits early suddenly looks like a smart strategy, even if folks live well into their 80s.

There’s just one problem: This scenario is total nonsense—unless the retirees in question have 100% in stocks. If they have at least some money in bonds and cash investments, and they live to their late 70s, they’d be better off spending down those conservative investments first, while they delay Social Security, because delaying Social Security would give them a higher effective return.

So why do folks cook up these convoluted justifications for claiming Social Security at age 62? It’s the same reason people won’t buy immediate fixed annuities. They simply hate the idea that they’ll postpone Social Security—and then fail to live long enough to get the benefit.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Seems So EasyMy Regrets and Playing Dumb

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wtfwjtd
wtfwjtd
1 year ago

Nice discussion! You could even connect #2 and #3, and point out that delaying Social Security buys you the most cost-effective immediate annuity available anywhere. And it’s inflation-adjusted, which makes it an unbeatable deal.

As for investing in stocks and getting a better return than SS gives you, that one has been debunked numerous times. Oh sure, with an after-tax AND after-inflation return of something like 4-5% +, it might be doable over the long haul. But, how many people have that kind of investing track record? And if you couldn’t earn that kind of return while investing during your working career, why do you believe you can earn it while retired? Sounds more like wishful thinking for most people to me, than an actual, fact- and evidence- based decision.
Or maybe, just maybe, more out-dated thinking from the ’80’s and ’90’s when those kinds of after-tax returns were more common. Even then, probably just fantasy for most people, as the “average” investor return even at that time was something like a total of 4-6%.

Roboticus Aquarius
Roboticus Aquarius
1 year ago
Reply to  wtfwjtd

That’s a good point about having to include the tax hit if you invest SS taken at 62. I hadn’t considered that before, and it’s probably a modest drag for most people, but very real for anyone with other income of what, $30K or more (Maybe someone familiar with the numbers can chime in. I am just starting to factor taxes into my retirement spreadsheet.)

Bob
Bob
1 year ago

Regarding Social Security, I figured the break even point of taking it at age 62 or waiting until my full retirement age of 66 and 10 months. That point was nearly 77 years of age! My traveling days will most likely be over by then. No thanks.

Secondly, every year I stay out of my investment accounts is a huge plus to the longevity of our savings. I’d rather peg my future on S&P 500 or IT Index Funds than a Social Security check.

Thirdly, I don’t care what anyone says, benefit cuts are looming with Social Security. Sure, Congress will “fix” Social Security at the eleventh hour, but not without some cuts. Those who wait until age 70 will be disappointed.

parkslope
parkslope
1 year ago
Reply to  Bob

My wife and I both waited until 70 and now have more than $81,000 in inflation-adjusted SS income (before taxes and Medicare deductions). We find that very reassuring and never cared about our break even points. It also minimizes the amount we need to take from our investment accounts.
Every past “fix” that Congress has made for SS has not affected those who were already receiving benefits or were anywhere close to being old enough to be eligible.

John C
John C
1 year ago

Those are interesting points to ponder Jonathan. I have a question regarding factoring in an immediate fixed annuity into one’s portfolio. If a person has a $1 mil portfolio and $400k in fixed income and then purchases $100K in an immediate annuity would it make sense the annuity should then be counted as 25% ($100k) of the fixed income portfolio? Or, would you determine the the annuity into the fixed income portfolio by the amount of income stream it generates? Thx

Jonathan Clements
Jonathan Clements
1 year ago
Reply to  John C

Interesting question. I’d view an immediate fixed annuity as a substitute for bonds — but, because an immediate annuity generates so much more income, you could potentially allocate more to stocks, thus raising your portfolio’s expected long-run return. As I approach retirement, that’s the bet I’m making — and I hope to live long enough to be proven right!

Rich Chambers
Rich Chambers
1 year ago

It always seemed to me that a way to analyze taking Social Security at the later age is that if you die late, you’ll sure welcome the larger amount. If you die early, then you didn’t need the money. There can be good reasons to start SS as early as possible but for most, late as possible is the better choice.

Jonathan Clements
Jonathan Clements
1 year ago
Reply to  Rich Chambers

Totally agree.

Roboticus Aquarius
Roboticus Aquarius
1 year ago

Great post! Your first point had me reconsidering my own approach.

I think annuities can be a great way to set yourself a permanent income ‘floor’ such that your basic needs are always met. I’d never put all my money in annuities for reasons both personal and not, but a substantial amount, yes.

As for Soc Sec… I’ve looked at this a hundred ways. Ok, really about 27, and I won’t go into the breakevens and everything else. The net is, yes, if I take SS early and invest it, and if I continue to earn the 9% or so CAGR I’ve earned these past decades, I’d come out ahead. However… each year you wait, you get a guaranteed 8% annual return on your ‘investment’, and it has a Cola on top of that! Are you kidding me? That’s investment nirvana for us little guys. Admittedly, the SS funding situation is tricky… a lot can happen in the 8 years you wait. I’m slated to retire right at the crux of this thing. I’m just planning for a 25% haircut on my SS and hoping for the best… but I plan to keep my ear to the ground.

David Lamb
David Lamb
8 months ago

Assuming SS continues to pay out 100% full benefits…

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